Advanced Accounting by Hoyle et al, 6th Edition

Chapter FiveConsolidated Financial StatementsIntra-Entity Asset Transactions

Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Learning Objective 5-2Demonstrate the consolidationprocedures to eliminate intra-entitysales and purchases balances.5-5Demonstrate the consolidationprocedures to eliminate intra-entitysales and purchasesbalances.Learning Objective 5-3Explain why consolidatedentities defer intra-entity grossprofit in ending inventory andthe consolidation proceduresrequired to recognize profitswhen actually earned.5-7Explain why consolidated entities defer intra-entity gross profit in ending inventory and the consolidation procedures required to recognize profits when actually earned.Intra-entity TransactionsFrom a consolidated perspective neither a sale nor a purchase has occurred. An intra-entity transfer is merely the internal movement of inventory that creates no net change in the financial position of the business combination taken as a whole.In the consolidated financial statements, the transfers are eliminated.The consolidated statements reflect only transactions with outside parties.Worksheet entries report the perspective of the consolidated enterprise.5-42From a consolidated perspective neither a sale nor a purchase has occurred. An intra-entity transfer is merely the internal movement of inventory, an event that creates no net change in the financial position of the business combination taken as a whole.When producing consolidated financial statements, the recorded effects of these transfers areeliminated so that consolidated statements reflect only transactions with outside parties.Worksheet entries serve this purpose; they adapt the financial information reported bythe separate companies to the perspective of the consolidated enterprise. The entire impactof the intra-entity transactions must be identified and then removed. Deleting theeffects of the actual transfer is described here first.Sales and Purchases-Intra-entityENTRY TI (Transferred Inventory)In a business combination, both parties record the transfer in their internal records as a normal sale/purchase. This consolidation worksheet entry is necessary to remove the resulting balances from the externally reported figures. Cost of Goods Sold is reduced here under the assumption that the Purchases account usually is closed out prior to the consolidation process.

5-63Sales and Purchases-Intra-entityENTRY TI (Transferred Inventory)In a business combination, both parties record the transfer in their internal records as a normal sale/purchase. This consolidation worksheet entry is necessary to remove the resulting balances from the externally reported figures. Cost of Goods Sold is reduced here under the assumption that the Purchases account usually is closed out prior to the consolidation process.If all of the transferred inventory is retained by the business combination at the end of the year, entry G eliminates the effects of the sellers gross profit that remains unrealized within the buyers ending inventory in year 1.

Unrealized Gross Profit Intra-entity Despite Entry TI, the inflated ending inventory figure causes cost of goods sold to be too low and profits to be too high . For consolidation purposes, the expense is increased by this amount through a worksheet adjustment that properly removes the unrealized gross profit from consolidated net income.

5-84Unrealized Gross Profit Intra-entity ENTRY G (Gross Profit)Despite Entry TI, the inflated ending inventory figure causes cost of goods sold to be too low and, thus, profits to be too high by $30,000. For consolidation purposes, the expense is increased by this amount through a worksheet adjustment that properly removes the unrealized gross profit from consolidatednet income.Consequently, if all of the transferred inventory is retained by the business combinationat the end of the year, the following worksheet entry also must be includedto eliminate the effects of the sellers gross profit that remains unrealized within thebuyers ending inventory in year 1.Unrealized Gross Profit Intra-entity Consoliation ENTRY G Year of Transfer (Year 1)Because the gross profit rate was 37 percent ($30,000 gross profit/$80,000 transfer price), this retained inventory is stated at a value $7,500 more than its original cost ($20,000 X 37%). The required reduction (Entry G ) is not the entire $30,000 shown previously but only the $7,500 unrealized gross profit that remains in ending inventory.

5-94Because the gross profit rate was 37 percent ($30,000 gross profit/$80,000 transfer price), this retained inventory is stated at a value $7,500 more than its original cost ($20,000 3 37%). The required reduction (Entry G ) is not the entire $30,000 shown previously but only the $7,500 unrealized gross profit that remains in ending inventory. Learning Objective 5-4Understand that the consolidationprocess for inventory transfers is designed to defer the unrealized portion of an intra- entity gross profit from the year of transfer into the year of disposal or consumption.5-10Understand that the consolidation process for inventory transfers is designed to defer the unrealized portion of an intra- entity gross profit from the year of transfer into the year of disposal or consumption.Unrealized Gross Profit Intra-entity In year 2, the overstatement is removed within the consolidation process but this time from the beginning inventory balance (which appears in the financial statements only as a positive component of cost of goods sold). This elimination is termed Entry *G. The asterisk indicates that a previous year transfer created the intra-entity gross profits.Entry *G removes unrealized gross profit from beginning figures so that it is recognized in the consolidated income in the period in which it is earned.

5-115Unrealized Gross Profit Intra-entity ENTRY *GIn year 2, the overstatement is removed within the consolidation process but this time from the beginning inventory balance (which appears in the financial statements only as a positive component of cost of goods sold). This elimination is termed Entry *G. The asterisk indicates that a previous year transfer created the intra-entity gross profits.Entry *G removes unrealized gross profit from beginning figures so that it is recognized in the consolidated income in the period in which it is earned.

Intra-entity Transactions Downstream TransfersEntry *G if the transfer of inventory is downstream AND the parent uses the equity method, the following entry is used to recognize the remaining unrealized profit left at the end of the previous year.Investment in Subsidiary account replaces the Retained Earnings account used for upstream sales.

5-126Intra-entity Transactions Downstream TransfersENTRY *GIf the transfer of inventory is downstream AND the parent uses the equity method, the following entry is used to recognize the remaining unrealized profit left at the end of the previous year. Investment in Subsidiary account replaces the Retained Earnings account used for upstream sales.

Unrealized Inventory Gain Downstream TransfersWorksheet entries to eliminate sales/purchases balances (Entry TI) and to remove unrealized gross profit from ending Inventory in Year 1 (Entry G) are standard, regardless of the circumstances of the consolidation. BUT the procedure to eliminate intra-entity gross profit from Year 2s beginning account balances differs from the Entry *G just presented IF:(1) the original transfer is downstream (parents) and(2) the parent applies the equity method for internal accounting purposes. 5-13Unrealized Inventory Gain Downstream TransfersWorksheet entries to eliminate sales/purchases balances (Entry TI) and to remove unrealized gross profit from ending Inventory in Year 1 (Entry G) are standard, regardless of the circumstances of the consolidation. BUT the procedure to eliminate intra-entity gross profit from Year 2s beginning account balances differs from the Entry *G just presented IF:(1) the original transfer is downstream (parents) and(2) the parent applies the equity method for internal accounting purposes.

Unrealized Inventory Gain - Downstream TransfersFor intra-entity beginning inventory profits resulting from downstream transfers when the parent applies the equity method:Parents retained earnings are appropriately stated due to intra-entity profit deferrals and recognition.The subsidiary retained earnings reflect none of the intra-entity profit and require no adjustment.The parents investment account at beginning of Year 2 contains a credit from the deferral of Year 1 downstream profits.Worksheet Entry *G transfers the Year 1 Investment account credit to a Year 2 earnings credit via COGS to recognize the profit in the year of sale to outsiders.5-149Unrealized Inventory Gain - Downstream TransfersFor intra-entity beginning inventory profits resulting from downstream transfers when the parent applies the equity method:Parents retained earnings are appropriately stated due to intra-entity profit deferrals and recognition.The subsidiary retained earnings reflect none of the intra-entity profit and require no adjustment.The parents investment account at beginning of Year 2 contains a credit from the deferral of Year 1 downstream profits.Worksheet Entry *G transfers the Year 1 Investment account credit to a Year 2 earnings credit via COGS to recognize the profit in the year of sale to outsiders.

Learning Objective 5-5Explain the difference betweenupstream and downstreamintra-entity transfers and howeach affects the computationof noncontrolling interestbalances.5-15Explain the difference between upstream and downstream intra-entity transfers and how each affects the computation of noncontrolling interest balances.Unrealized Gross Profits Effect on Noncontrolling InterestAccording to FASB ASC paragraph 810-10-45-6:

The amount of intra-entity profit or loss to be eliminated is not affected by the existence of a noncontrolling interest.

The complete elimination of the intra-entity profit or loss is consistent with the underlying assumption that consolidated financial statements represent the financial position and operating results of a single economic entity.

The elimination of the intra-entity profit or loss may be allocated proportionately between the parent and noncontrolling interest.5-16Unrealized Gross Profits Effect on Noncontrolling InterestAccording to FASB ASC paragraph 810-10-45-6:

The amount of intra-entity profit or loss to be eliminated is not affected by the existence of a noncontrolling interest.

The complete elimination of the intra-entity profit or loss is consistent with the underlying assumption that consolidated financial statements represent the financial position and operating results of a single economic entity.

The elimination of the intra-entity profit or loss may be allocated proportionately between the parent and noncontrolling interest.

Unrealized Gross Profits Effect on Noncontrolling InterestAccounts affected by intra-entity transactions: Revenues Cost of Goods SoldExpensesNoncontrolling Interest in Subsidiarys Net IncomeRetained Earnings at the Beginning of the YearInventoryLand, Buildings, and Equipment Noncontrolling Interest in Subsidiary at End of Year.5-17Unrealized Gross Profits Effect on Noncontrolling InterestAccounts affected by intra-entity transactions: Revenues Cost of Goods SoldExpensesNoncontrolling Interest in Subsidiarys Net IncomeRetained Earnings at the Beginning of the YearInventoryLand, Buildings, and Equipment Noncontrolling Interest in Subsidiary at End of Year.

Intra-Entity Inventory Downstream Transfer - ExampleTop Company acquires 80 percent of the voting stock of Bottom Company on January 1, 2012. Top pays $400,000.Acquisition-date fair value of noncontrolling interest is $100,000. Top allocates the entire $50,000 excess fair value over book value to adjust a database owned by Bottom to fair value. The database has an estimated remaining life of 20 years.5-18Intra-Entity Inventory Downstream Transfer - ExampleTop Company acquires 80 percent of the voting stock of Bottom Company on January 1, 2012. Top pays $400,000.Acquisition-date fair value of noncontrolling interest is $100,000. Top allocates the entire $50,000 excess fair value over book value to adjust a database owned by Bottom to fair value. The database has an estimated remaininglife of 20 years.

Intra-Entity Inventory Downstream Transfer - ExampleThe subsidiary reports net income of $30,000 in 2014 and $70,000 in 2015, the current year.

Dividends declared are $20,000 in the first year and $50,000 in the second.

A $10,000 intra-entity receivable and payable exists as of December 31, 2015.

Intra-entity inventory transfers between the two companies: 2014 2015Transfer prices . . . . . . . . . . . . . . . . . . . . . . . . $80,000 $100,000Historical cost . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 70,000Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000 $ 30,000Year-end Inventory balance (transfer price) $16,000 $ 20,000Gross profit percentage . . . . . . . . . . . . . . . . . . . .X 25% X30%Gross profit remaining in year-end inventory$ 4,000 $ 6,000

5-19Intra-Entity Inventory Downstream Transfer - ExampleThe subsidiary reports net income of $30,000 in 2014 and $70,000 in 2015, the current year.

Dividends declared are $20,000 in the first year and $50,000 in the second.

A $10,000 intra-entity debt exists as of December 31, 2015.

Intra-entity inventory transfers between the two companies: 2012 2013Transfer prices . . . . . . . . . . . . . . . . . . . . . . . . $80,000 $100,000Historical cost . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 70,000Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000 $ 30,000Year-end Inventory balance (transfer price) $16,000 $ 20,000Gross profit percentage . . . . . . . . . . . . . . . . . . . . X 25% X30%Gross profit remaining in year-end inventory $ 4,000 $ 6,000

Intra-Entity Inventory Transfers ExampleThree entries require attention in the calculation of noncontrolling interest in the subs net income December 31, 2015.

Entry *G removes unrealized gross profits (25% rate) carried over from the previous period intra-entity downstream sales. Entry *G reduces Cost of Goods Sold (or beginning inventory component) which creates an increase in current year income. Gross profit is correctly recognized in 2015 when inventory is sold to an outside party. The debit to the Investment in Bottom account brings that account to a zero balance in consolidation.

5-20Intra-Entity Inventory Transfers ExampleThree entries require attention in the calculation of noncontrolling interest in the subs net income December 31, 2015.Entry *G removes unrealized gross profits (25% rate) carried over from the previous period intra-entity downstream sales. Entry *G reduces Cost of Goods Sold (or beginning inventory component) which creates an increase in current year income. Gross profit is correctly recognized in 2015 when inventory is sold to an outside party. The debit to the Investment in Bottom account brings that account to a zero balance in consolidation.

Intra-Entity Inventory Downstream Transfer - ExampleEntry TI eliminates the intra-entity sales/purchases for 2015.

Entry G defers the unrealized gross profit (30% rate) of $6,000remaining at the end of 2015.

Entry G eliminates the overstatement of Inventory as well as the ending component of Cost of Goods Sold which decreases consolidated income.

5-21Entry TI eliminates the intra-entity sales/purchases for 2015. Entry G defers the unrealized gross profit (30% rate) of $6,000remaining at the end of 2015. Entry G eliminates the overstatement of Inventory as well as the ending component of Cost of Goods Sold which decreases consolidated income.

Intra-entity Transactions Upstream Inventory Transfer A different set of consolidation procedures is necessary if the intra-entity transfers are upstream. Upstream gross profits are attributed to the subsidiary, Bottom, not the parent, Top. Because inventory transfers are upstream from Bottom to Top, only 80% of the profit deferral and subsequent recognition is allocated to the parents equity earnings and investment account.Intra-entity profit reallocation across time affects both the subsidiarys reported income and the noncontrolling interest.5-228A different set of consolidation procedures is necessary if the intra-entity transfers are upstream. Upstream gross profits are attributed to the subsidiary, Bottom, not the parent, Top. Because inventory transfers are upstream from Bottom to Top, only 80% of the profit deferral and subsequent recognition is allocated to the parents equity earnings and investment account.Intra-entity profit reallocation across time affects both the subsidiarys reported income and the noncontrolling interest.

Intra-entity Transactions Upstream Inventory Transfer The records of the two companies change to reflect the parents application of the equity method for upstream sales.

(Entry *G) reduces Bottoms beginning 2015 Retained Earnings balance, and decreases Cost of Goods Sold which increases consolidated net income to recognize profit earned in 2015 by sales to outsiders.5-238The records of the two companies change to reflect the parents application of the equity method for upstream sales. (Entry *G) reduces Bottoms beginning 2015 Retained Earnings balance, and decreases Cost of Goods Sold which increases consolidated net income to recognize profit earned in 2015 by sales to outsiders.Intra-entity Transactions Upstream Inventory Transfer As of January 1, 2015, $16,000 of transfers remain inTops inventory, and $4,000 of gross profit (25%) is unearned from a consolidated perspective. Also, Bottoms beginning Retained Earnings are overstated by $4,000, the gross profit from 2014 intra-entity transfers.

A credit to Cost of Goods Sold increases consolidated net income to recognize that the profit has been earned in 2015 by sales to outsiders.

5-24As of January 1, 2015, $16,000 of transfers remain inTops inventory, and $4,000 of gross profit (25%) is unearned from a consolidated perspective. Also, Bottoms beginning Retained Earnings are overstated by $4,000, the gross profit from 2014 intra-entity transfers. A credit to Cost of Goods Sold increases consolidated net income to recognize that the profit has been earned in 2015 by sales to outsiders.

Intra-entity Transactions Upstream Inventory TransferEntry S eliminates a portion of the parents investment account and provides the initial noncontrolling interest balance. The entry also removes stockholders equity accounts of the subsidiary as of the beginning of the current year.

5-258Entry S eliminates a portion of the parents investment account and provides the initial noncontrolling interest balance. The entry also removes stockholders equity accounts of the subsidiary as of the beginning of the current year.

Intra-entity Transactions Upstream vs. Downstream transfersCompare the Entry *G for the downstream and upstream transfers to see the difference in the transactions.

The effect of downstream and upstream transfers when the parent uses the equity method are compared in more detail.5-26Compare the Entry *G for the downstream and upstream transfers to see the difference in the transactions. Intra-entity Transactions Upstream vs. Downstream transfers

5-278To better understand how the Entry S differs, compare the entries for the downstream and upstream transfers.

Learning Objective 5-6Prepare the consolidation entryto remove any unrealizedgain created by the intra-entitytransfer of land from the accountingrecords of the year of transfer and subsequent years.5-28Prepare the consolidation entry to remove any unrealized gain created by the intra-entity transfer of land from the accounting records of the year of transfer and subsequent years.Intra-entity Transactions Land TransferENTRY TLIf land is transferred between the parent and sub at a gain, the gain is considered unrealized and must be eliminated. By crediting land for the same amount, this effectively returns the land to its carrying value on the date of transfer.

5-2910Intra-entity Transactions Land TransferENTRY TLIf land is transferred between the parent and sub at a gain, the gain is considered unrealized and must be eliminated. Note: By crediting land for the same amount, this effectively returns the land to its carrying value on the date of transfer.

Intra-entity Transactions --Land Transfer ENTRY *GLAs long as the land remains on the books of the buyer, the unrealized gain must be eliminated at the end of each fiscal period.The original gain was closed to R/E at the end of that period. To eliminate the gain in subsequent years, it must come from R/E.

5-3011Intra-entity Transactions --Land Transfer ENTRY *GLAs long as the land remains on the books of the buyer, the unrealized gain must be eliminated at the end of each fiscal period.Note: The original gain was closed to R/E at the end of that period. When we eliminate the gain in subsequent years, it must come from R/E.

Intra-entity Land TransfersEliminating Unrealized GainsENTRY *GL (Year of sale)In the period the land is sold to a third party, the unrealized gain must be eliminated one more time, and also finally recognized as a REALIZED gain in the current periods consolidated financial statements.

5-3112Intra-entity Land TransfersEliminating Unrealized GainsENTRY *GL (Year of sale)In the period the land is sold to a third party, the unrealized gain must be eliminated one more time, and also finally recognized as a REALIZED gain in the current periods consolidated financial statements. Note: Modify the entry to credit the Gain account instead of Land.

The Effect of Land Transfers on Noncontrolling InterestsDOWNSTREAM transfers have no effect on noncontrolling interest.UPSTREAM transfers have a gain on the SUBSIDIARY books!All noncontrolling interest balances are based on the subs net income EXCLUDING the intra-entity gain.5-32DOWNSTREAM transfers have no effect on noncontrolling interest.UPSTREAM transfers have a gain on the SUBSIDIARY books!All noncontrolling interest balances are based on the subs net income EXCLUDING the intra-entity gain.